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There are risks associated with investing in anything - whether it be corporate bonds, government securities, or common stock - and the only way to minimize risk is to understand what you are purchasing and to address the risks associated with your investment before you make it. Preferreds are unique in that they have traits that make them similar to both stocks and bonds and therefore the investment risks are distinct as well. Bank Preferreds, like each subsector of the preferred stock universe, have additional risks associated with the financial sector. Since I have been writing about Bank Preferreds (and plan to continue doing so), I think it's important for potential investors to understand the risks associated with these investments.

I am going to classify risks as two types - individual and sector. Individual risks will address position-specific risks while the sector risks have to do with the bigger picture.

Individual Risks

Liquidity Risk

Each preferred stock is going to have a different amount that is traded on an average day. As an investor, you need to decide if this amount provides you with enough comfort that you will be able to trade in and sell out of your position without having to take a major price hit due to inadequate liquidity. The average volume that provides enough liquidity to be comfortable is going to vary for every investor. That being said, I think a good baseline for an investor thinking about getting into the bank preferred market is 100,000+ shares for the 10-day average volume. As you become more comfortable your required liquidity may shift down, but this means that initially someone buying 100 shares is having more than 1,000 times the number of shares that they own trade every day.

Premium Risk

This is the amount above the call price (typically the same as par price in bank preferreds) that you are paying. If you purchase preferred shares at $26.50 that have a call price of $25, then you are paying a premium of $1.50. How long that premium risk is outstanding depends on the coupon - at 5% it's going to take five quarters to recapture that premium (annual dividend of $1.25 or quarterly dividend of $0.3125, so after five quarters you will receive $1.5625 in dividend payments) whereas at 8% it's going to take three quarters (annual dividend of $2.00 or quarterly dividend of $0.50, so after three quarters you will receive $1.50). I think an investor new to the bank preferreds sector should focus on securities that have a maximum premium recapture period of 2-3 quarters.

Call Risk

Bank preferreds are issued with a call date (the date that the company has the right to purchase back the preferred stock at the call price) that is generally five years from the date of issue (although this varies depending on the specific security). Generally once the call date has passed, the company has the right to call the security quarterly. It's important to understand the call risk as it goes hand-in-hand with the premium risk. A couple of questions that you should ask yourself when analyzing a new bank preferred stock as a potential investment are:

  • How long until the preferred can be called (quarters or years)?
  • If the call date has passed, how much of a premium are you willing to pay?
  • What's the likelihood that the company will call the preferred at the call date? What has it done in the past with other preferreds?
  • What is the rate of this preferred versus the rate that the company can get by issuing a new preferred?
  • Can the preferred be called prior to the call date?

This last question is especially important when analyzing bank preferreds. Essentially all bank preferreds have an early call provision for change in the treatment of capital. When the Fed announced earlier this year that Trust Preferred Securities (TruPS) would no longer be treated as Tier 1 capital, this allowed banks to call the securities early. Since rates have gone down since many of the TruPS were originally issued, banks called the securities because it allowed them to issue Traditional Preferreds at a lower rate and still have them be treated as Tier 1 capital.

Risk of Missing Dividend Payments

Many bank preferreds are noncumulative, meaning if they miss a dividend payment they are under no obligation to "pay you back" the missed dividend amount. While at first pass it may sound like a company can mess around with dividend payments to avoid its obligations, this is not the case at all. Companies understand the implications of missing a dividend payment - the price of preferred and common stock will sharply decline as it is a sign of serious financial distress. It is also important to note that companies cannot pay a dividend on their common stock without paying their preferred dividends first.

While we are constantly reminded that past performance is not indicative of future results, there is something to be said for how a company has acted over time. Take a look at the common stock - is it currently paying a dividend? How long has it paid the dividend? Has the company always paid the dividend on its preferreds?

If a company is going to miss a dividend payment it shouldn't be something that sneaks up on you - you should take a look at its financial health and have a basic understanding of the businesses prior to investing. Missing dividend payments is a sign of serious issues and if it misses one, it's probably not going to stop there.

Default Risk (Bankruptcy)

If a preferred stock is not receiving dividend payments, there is always the chance that the company does not recover and is eventually forced to declare bankruptcy. While this may seem like a drastic scenario, it's not unheard of. During the financial crisis, many of the preferreds that defaulted were bank preferreds.

In order to mitigate this risk, an investor needs to understand the underlying businesses of a company. For a financial institution, does it make the bulk of its profits from lending activities or does it drive a substantial amount of p&l from trading? How well capitalized is the institution? Has it had any signs of recent issues?

If the company is in trouble it isn't necessarily the case that it is going to default on its obligations - there is the chance that the whole company is acquired, in which case your preferred is now part of the capital structure of the acquiring company (this happened with Countrywide and Merrill Lynch preferreds becoming Bank of America obligations, Bear Stearns becoming part of JP Morgan, Wachovia part of Wells Fargo, etc.). There is always a chance, though, that the company is not acquired in full - take Lehman Brothers for example. Barclays did not acquire the full company and instead purchased the core businesses and assets, and therefore the preferreds were (and are) still obligations of the Lehman Brothers estate.

Sector Risks

Rising Rates

Rates are currently at an all-time low, so eventually they will rise. When this happens and how quickly is up for debate, but when rates do rise, the price of fixed preferreds issued at these extremely low rates will fall. If, when rates rise, a bank can suddenly only issue a preferred at 8.5% but has issued in the past at 6%, the price of the 6% preferred will fall so that the effective yield will be more competitive with the newer issue.

Since most bank preferreds that are being issued right now are fixed rate, this means that they are all susceptible to this price drop when rates begin to rise. You can protect yourself in a number of ways:

  • Pay attention to the Fed announcements about rates. Rates will eventually begin to rise, but it won't come as a surprise if you pay attention to it.
  • If you are really worried about it, buy Fixed-to-Floating preferreds or pure Floating preferreds. You will have a lower yield now but as rates begin to rise, so will your coupon.

Inflation Risk

Inflation risk, pure and simple, is the idea that $1 today is worth less tomorrow and even less the next day. If you are purchasing fixed rate preferreds at a 6% coupon (meaning you are receiving $1.50 annually on a $25 par preferred) you will be receiving the same amount in dividend payments every year but this amount will have less and less purchasing power as time goes on. Keep this in mind as you buy preferreds and any other investments that you may hold for a long time.

Tax Cut Expiration

The dividends that are paid on many bank preferreds currently qualify for the 15% tax rate. If the taxation of these dividends returns to normal income tax rates, then the after-tax yield on these securities is going to decrease. This will make the after-tax yield look worse when compared with other securities that were not taxed at 15% to begin with (e.g. the after-tax yield on these securities will not change). Dividends on preferred stocks of REITs, for example, are not currently taxed at 15%. Prices may drop on bank preferreds as a result of this, but keep in mind that the call price does not change.

Other Things to Take into Consideration

Total Return

If you are a total return investor, then buying bank preferreds near par probably is not the right trade for you. Generally when buying bank preferreds you are investing (rather than trading) for stable dividend cash flow and not for price appreciation (since bank preferreds will eventually be called at the call price, the price is not going to stray a huge amount). The price may trade up from $25 to $28 (12% increase in price!) in the best-case scenario, but that isn't anything compared with buying Bank of America common stock at $6 in January 2012 and trading out at $10.50 in December (75% increase in price!). If you are interested in the total return trade within the bank preferreds universe then buying distressed positions is probably more in your wheelhouse - although this type of investing comes with its own set of risks.

Capital Ratios

Federal banking agencies require that various regulatory capital measurements be maintained by banks and bank holding companies. If they are not met, the bank is subject to prompt corrective action. Three ratios that are calculated by every bank and shown in quarterly filings are the Tier 1 Leverage Capital Ratio, Tier 1 Capital Ratio, and Total Risk-Based Capital Ratio. The classifications for the different ratio levels are as follows:

Capitalization Ratios
(Click to enlarge)

These capital ratios are out there for a reason and you should use them to your advantage. Play it safe and only buy preferred stocks of banks that can be classified as Well Capitalized.

Ratings

Securities are rated for a reason and you should use these ratings to your advantage. Because of where preferred stocks are in the capital structure (below junior debt but above common stock) there are not going to be AAA rated bank preferreds. There are, however, investment-grade preferreds out there or just below investment-grade preferreds. As an investor in bank preferreds, the financial stability of the bank itself is also important so you can look at the long-term debt ratings (and other available ratings) as well. These ratings can generally be found on the investor relations section of a bank's website.

Price Fluctuations

Price changes occur on a daily basis in preferreds but it's important to not get caught up on intra-day movement and to focus on the long-term investment. There are days when the financial sector is down as a whole and as a result bank preferreds are down as well, and there are days when the opposite is true. It's important to remember that if you are buying for a long-term dividend and eventual call that movement on a day-to-day basis is not the end of the world because there is always a call price that the preferred should eventually trade toward.

There are also times when price movements can be expected and you can use it to your advantage. For example, much like common stocks, bank preferreds will trade down on the day that they trade ex-div (the day that you will no longer receive the upcoming dividend). There are cases where the price historically drops by more than the upcoming dividend - the right move may be to wait and purchase that preferred on the ex-div date instead of the days leading up to it. There are also cases where the price does not historically move as much as the dividend payment, so with that knowledge purchasing the security prior to the ex-div date may be the right investment decision.

Final Thoughts

There are many risks associated with investing in any asset class and the best way to minimize these risks is to address them prior to investing. With bank preferreds, investors (and especially new investors) should take a disciplined approach by setting limits to various exposures and how much risk they want to take (perhaps even start by only investing in bank preferreds where any premium will be recaptured within one quarter). By analyzing the right risk metrics and understanding the banks that have issued the preferred stock, investors can minimize risk while gaining stable long-term dividends.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Navigating The Risks Of Buying Bank Preferred Stocks